Egr403 sv5 Chapter3

Chapter 3 - Interest
and Equivalence
Click here for Streaming Audio To
Accompany Presentation (optional)
EGR 403 Capital Allocation Theory
Dr. Phillip R. Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona
EGR 403 - Cal Poly Pomona - SA5 2
EGR 403 - The Big Picture
Framework: Accounting & Breakeven Analysis
Time-value of money concepts - Ch. 3, 4
Analysis methods
Ch. 5 - Present Worth
Ch. 6 - Annual Worth
Ch. 7, 8 - Rate of Return (incremental analysis)
Ch. 9 - Benefit Cost Ratio & other techniques
Refining the analysis
Ch. 10, 11 - Depreciation & Taxes
Ch. 12 - Replacement Analysis
Economic Decision Components
Where economic decisions are immediate we need
to consider:
amount of expenditure
taxes
Where economic decisions occur over a
considerable period of time we need to also
consider the consequences of:
interest
inflation

Computing Cash Flows
Cash flows have:
Costs (disbursements) a negative number
Benefits (receipts) a positive number
Example 3-1
End of
Year Cash flow
0 (1,000.00) $
1 580.00 $
2 580.00 $
Time Value of Money
Money has value
Money can be leased or rented
The payment is called interest
If you put $100 in a bank at 9% interest for one time
period you will receive back your original $100 plus $9
Original amount to be returned = $100
Interest to be returned = $100 x .09 = $9
Simple Interest
Interest that is computed only on the original
sum or principal
Total interest earned = I = P i n , where:
P = present sum of money, or principal (example:
$1000)
i = interest rate (10% interest is a .10 interest rate)
n = number of periods (years) (example: n = 2 years)
I = $1000 x .10/period x 2 periods = $200
Future Value of a Loan With
Simple Interest
Amount of money due at the end of a loan
F = P + P i n or F = P (1 + i n )
Where,
F = future value
F = $1000 (1 + .10 x 2) = $1200
Simple interest is not used today
Compound Interest
Compound Interest is used and is computed
on the original unpaid debt and the unpaid
interest.
Year 1 interest = $1000 (.10) = $100
Year 2 principal is, therefore:
$1000 + $100 = $1100
Year 2 interest = $1100 (.10) = $110
Total interest earned is: $100 + $110 = $210
This is $10 more than with simple interest
Compound Interest (Contd)
Future Value (F) = P + Pi + (P + Pi)i
= P (1 + i + i + i
2
) = P (1+i)
2
= 1000 (1 + .10)
2
= 1210
In general, for any value of n:
Future Value (F) = P (1+i)
n

Total interest earned = I
n
= P (1+i)
n
- P
Where,
P present sum of money
i interest rate per period
n number of periods
Compound Interest Over Time
If you loaned a friend
money for short period
of time the difference
between simple and
compound interest is
negligible.
If you loaned a friend
money for a long period
of time the difference
between simple and
compound interest may
amount to a considerable
difference.

P n i% F
1000 1 10% $1,100.00
1000 2 10% $1,210.00
1000 3 10% $1,331.00
1000 10 10% $2,593.74
1000 20 10% $6,727.50
1000 30 10% $17,449.40
1000 40 10% $45,259.26
Nominal and Effective Interest
Interest rates are normally given on an annual basis with
agreement on how often compounding will occur (e.g., monthly,
quarterly, annually, continuous).
Nominal interest rate /year ( r ) the annual interest rate w/o
considering the effect of any compounding (e.g., r = 12%).
Interest rate /period ( i ) the nominal interest rate /year
divided by the number of interest compounding periods (e.g.,
monthly compounding: i = 12% / 12 months/year = 1%).
Effective interest rate /year ( i
eff
or APR ) the annual interest
rate taking into account the effect of the multiple compounding
periods in the year. (e.g., as shown later, r = 12% compounded
monthly is equivalent to 12.68% year compounded yearly.
Interest Rates (contd)
We use i for the periodic interest rate
Nominal interest rate = r (an annual rate)
Number of compounding periods/year = m
r = i * m, and i = r / m
Let r = .12 (or 12%)

Interest Period m = interest periods /
year
i = interest rate / period
Annual 1 .12
Quarter 4 .03
Month 12 .01
Effective Interest
If there are more than one compounding periods during
the year, then the compounding makes the true interest
rate slightly higher. This higher rate is called the
effective interest rate or Annual Percentage Rate
(APR)
i
eff
= (1 + i)
m
1 or
i
eff
= (1 + r/m)
m
1
Example: r = 12, m = 12
i
eff
= (1 + .12/12)
12
1 = (1.01)
12
1 = .1268 or 12.68%
Consider Four Ways to Repay a Debt
Compound and
pay at end of
loan
Interest on
unpaid balance
Interest on
unpaid balance
Repay Interest
Declines at
increasing rate
Equal installments 3
Compounds at
increasing rate
until end of loan
End of loan 4
Constant End of loan 2
Declines Equal
installments
1
Interest Earned Repay
Principal
Plan
Plan 1 Equal annual
principal payments
Year Balance P i Payment
1 5000 1000 500 1500
2 4000 1000 400 1400
3 3000 1000 300 1300
4 2000 1000 200 1200
5 1000 1000 100 1100
6500
Plan 2 Annual interest + balloon
payment of principal
1 5000 500 500
2 5000 500 500
3 5000 500 500
4 5000 500 500
5 5000 5000 500 500
7500
Plan 3 Equal annual payments
(installments)
1 5000.00 819.00 500.00 1319
2 4181.00 900.90 418.10 1319
3 3280.10 990.99 328.01 1319
4 2289.11 1090.09 228.91 1319
5 1199.02 1199.10 119.90 1319
6595
Plan 4 Principal & interest at
end of the loan
1 5000 0 500 0
2 5500 0 550 0
3 6050 0 605 0
4 6655 0 665.50 0
5 7320.50 0 732.05 8052.55
8052.55
Which plan would you choose?
Total Principal + Interest Paid
Plan 1 = $6500
Plan 2 = $7500
Plan 3 = $6595
Plan 4 = $8052.55
Equivalence
When an organization is indifferent as to whether
it has a present sum of money now or, with
interest the assurance of some other sum of money
in the future, or a series of future sums of money,
we say that the present sum of money is
equivalent to the future sum or series of future
sums.
Each of the four repayment plans are equivalent
because each repays $5000 at the same 10% interest rate.
To further illustrate this concept, given the choice
of these two plans which would you choose?
$7000 $6200 Total
5400 1080 5
400 1160 4
400 1240 3
400 1320 2
$400 $1400 1
Plan 2 Plan 1 Year
To make a choice the cash flows must be
altered so a comparison may be made.
Technique of Equivalence
Determine a single equivalent value at a
point in time for plan 1.
Determine a single equivalent value at a
point in time for plan 2.
Both at the same interest rate
Judge the relative attractiveness of the two
alternatives from the comparable equivalent
values. You will learn a number of methods
for finding comparable equivalent values.
Analysis Methods that Compare
Equivalent Values
Present Worth Analysis (Ch. 5) - Find the equivalent value of
cash flows at time 0.
Annual Worth Analysis (Ch. 6) - Find the equivalent annual
worth of all cash flows.
Rate of Return Analysis (Ch. 7, 8) - Compare the interest rate
(ROR) of each alternatives cash flows to a minimum value you
will accept.
Future Worth Analysis (Ch. 9) - Find the equivalent value of
cash flows at time in the future.
Benefit/Cost Ratio (Ch. 9) - Use equivalent values of cash flows
to form ratios that can be easily analyzed.
Interest Formulas
To understand equivalence the underlying
interest formulas must be analyzed. We will
start with Single Payment interest formulas.
Notation:
i = Interest rate per interest period.
n = Number of interest periods.
P = Present sum of money (Present worth, PV).
F = Future sum of money (Future worth, FV).
If you know any three of the above variables
you can find the fourth one.
For example, given F, P, and n, find
the interest rate (i) or ROR
Principal outstanding over time (P)
Amount repaid (F) at n future periods from now
We know F, P, and n and want to find the interest rate
that makes them equivalent:

If F = P (1 + i)
n
Then i = (F/P)
1/n
- 1

This value of i is the Rate Of Return or ROR for
investing the amount P to earn the future sum F
Functional Notation
Give P, n, and i, we can solve for F several ways:
Use the formula and a calculator
Use the factors and functional notation in the tables in
the back of the text
Use the financial functions (f
x
) in EXCEL
Use the financial functions available in many
calculators
In this course we will use the factors or EXCEL
spreadsheet functions unless otherwise instructed
Cash Flow Diagrams
We use cash flow
diagrams to help
organize the data for
each alternative.
Down arrow -
disbursement cash flow
Up arrow - Income cash
flow
n = number of
compounding periods
in the problem
i = interest rate/period
Notation for
Calculating a Future Value
Formula:
F=P(1+i)
n
is the
single payment compound amount factor.
Functional notation:
F=P(F/P, i, n) F = 5000(F/P, 6%, 10)
F =P(F/P) which is dimensionally correct.
Find the factor values in the tables in the
back of the text.
Using the Functional Notation and
Tables to Find the Factor Values
F = 5000(F/P, 6%, 10)
To use the tables:
Step 1: Find the page with the 6% table
Step 2: Find the F/P column
Step 3: Go down the F/P column to n = 10
The Factor shown is 1.791, therefore:
F = 5000 (1.791) = $8955
Using EXCEL Spreadsheet Functions
On the menu bar select the f
x
icon
Select the Financial Function menu
Select the FV function to find the Future Value of a
present sum (or series of payments):
FV(rate, nper, pmt, PV, type) where:
rate = i
nper = n
pmt = 0
PV = P
type = 0
Notation for
Calculating a Present Value
P=F(1/1+i)
n
=F(1+i)
-n
is the
single payment present worth factor
Functional notation:
P=F(P/F, i, n) P=5000(P/F, 6%, 10)

Example: P=F(P/F, i, n)
F = $1000, i = 0.10, n = 5, P = ?

Using notation: P = F(P/F, 10%, 5)
= $1000(.6209) = $620.90

Egr403 sv5 Chapter3

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Egr403 sv5 Chapter3

Încărcat de

Drepturi de autor:

Formate disponibile

Chapter 3 - Interest

S-ar putea să vă placă și